A Delicate Balance

You know something's up when both the secretary of the Treasury and the chairman of the Federal Reserve give speeches calling for a new mechanism to allow them to manage the orderly liquidation of a major financial institution.

You have a sense that things are getting desperate when General Motors has to offer six-year loans at zero-percent interest to unload its gas-guzzling trucks and SUVs, and people openly speculate about how long it will be before the automaker runs out of cash.

And you can feel the foundation shaking under Wall Street when Fannie Mae and Freddie Mac have to pay three-quarters of a percentage point more to borrow money than the U.S. Treasury, which implicitly guarantees their debt, and top government officials feel compelled to reaffirm their support.

We're nearing that delicate point in the cycle when even the usual cheerleaders have hung up their pompoms, consumer and business confidence has disappeared and investors are driven mostly by fear rather than greed.

What started out as a credit crisis and then morphed into a broader financial crisis has finally worked its way into the real economy. That economic downturn -- a recession, inevitably -- is beginning to wash back on the already weakened financial sector, creating the kind of self-reinforcing vicious cycle that is difficult to control.

This is the way a market economy corrects for its excesses -- in this case, an excess of cheap debt that had the effect of inflating the demand for goods and services and the value of stocks, bonds, real estate and commodities. Now that that cheap credit has disappeared, the value of most of those assets has fallen while some of that demand for goods and services has begun to disappear.

As part of that "de-leveraging" process, households and some businesses are being forced to reduce their indebtedness, either by paying it down or admitting that they can't. But it is in the financial sector, where debt was piled on debt in ever-more complex arrangements, that things have begun to get real dicey. Prices for many credit instruments have collapsed, forcing banks and investment houses to take billions of dollars of real or paper losses. Meanwhile, creating new credit has been dramatically curtailed.

In such an environment, it is understandable that regulators want to force banks and other financial institutions to raise large amounts of fresh equity capital to replenish what has been written off. It is encouraging that regulators want to demonstrate that they have learned from their past mistakes by clamping down on loose lending and requiring more honest accounting. But there is a danger in pushing these things too fast and too far.

While it may make sense, for example, to require any one institution to raise billions of dollars in new capital from equity investors, it may be unwise to make all of them raise it all at the same time. The effect may be to unnecessarily increase the cost of that capital, drive down already-depressed stock prices, jeopardize credit ratings and raise borrowing costs -- hardly a winning strategy for nursing a financial institution back to health.

Similarly, we all applaud the belated effort of accounting regulators to prevent institutions from hiding liabilities or avoiding capital rules through use of "off-balance sheet" vehicles. But requiring them to make the changes now, in the middle of a credit crisis, is a bit like throwing gasoline on a fire you're trying to put out.

There's also the hot issue in regulatory circles of "fair value accounting," which has to do with how to assign a value to complex securities that are in such bad odor that they can be sold only at a deep discount to the value of the assets that lay behind them.

Accounting purists want to force banks to value these securities at current market prices and take the huge write-downs, arguing that if and when the markets recover, they can record a profit in future quarters. But things will never get to that point if, as a result of massive write-downs, these institutions are put out of business or forced to raise cash by selling the securities into already-depressed markets.

A financial crisis like this one calls for policymakers and regulators who can keep a cool head and remain flexible and practical rather than insisting on strict adherence to economic orthodoxies. Not every instance of regulatory forbearance need be viewed as a step down a slippery slope toward Japanlike stagnation. Nor is it particularly constructive to characterize every instance of government involvement in the private sector -- whether it be refinancing a troubled home mortgage, opening the Fed lending window to cash-strapped investment banks or orchestrating a private-sector rescue of a failing hedge fund -- as a massive government bailout.

As for Fannie and Freddie, nobody would be particularly happy if it became necessary for the Treasury to inject some fresh capital into the mortgage giants, in exchange, say, for newly issued preferred stock that could be sold back at a profit when the mortgage market recovers. But even the editorialists at the Wall Street Journal acknowledged yesterday that this wee bit of socialism might be the most effective and least costly way to keep the mortgage market functioning and prevent a meltdown in global credit markets.

A financial crisis is not a morality play. What matters most isn't the precedents that are set, the amount of taxpayer money that's implicated or whether people are made to suffer fully for their financial misjudgments. In the end, what matters most is that we get through it as quickly as possible with an economy and a financial system intact.

Steven Pearlstein will host a Web discussion at 11 a.m. today at washingtonpost.com. He can be reached at pearlsteins@washpost.com.